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The right tax climate is the right way to seed growth

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State legislators, aware of their states' business tax climates, are frequently tempted to woo business with lucrative tax incentives and subsidies instead of broad-based tax reform, which can be a "dangerous proposition," according to Joshua Barro, staff economist at the Washington-based Tax Foundation.

In a research paper on the 2009 State Business Tax Climate Index, released in October, Barro points to Florida, whose lawmakers were angered in 2004 when a credit card issuer decided to close a call center—laying off more than 1,100 employees—after receiving $3 million in state tax breaks over the previous nine years.

Lawmakers offer such deals to create jobs and develop the economy, but "if a state needs to offer such packages it is most likely covering for a woeful business tax climate," he said. A far more effective approach "is to systematically improve the business tax climate for the long term so as to improve the state's competitiveness."

Business taxes affect business decisions, job creation and retention, plant location, competitiveness, the transparency of the tax system and the long-term health of a state's economy. Most importantly, "taxes diminish profits," Barro said. "If taxes take a larger portion of profits, that cost is passed along to consumers through higher prices; (to) workers through lower wages or fewer jobs; or shareholders through lower dividends or share value."

This means a state with lower overall tax costs will be more attractive to business investment and more likely to experience economic growth. The ideal tax system—local, state or federal—is simple, transparent, stable, neutral to business activity and pro-growth, he said.

The Tax Foundation lists Wyoming, South Dakota, Nevada, Alaska, Florida, Montana, Texas, New Hampshire, Oregon and Delaware as the 10 states with the best business tax climates; Minnesota, Nebraska, Vermont, Iowa, Maryland, Rhode Island, Ohio, California, New York and New Jersey are said to be the 10 states with the worst business tax climates.

A study by a Massachusetts institute largely agrees with the Tax Foundation's findings, saying that reforms in that state would create transparency, eliminate loopholes and create long-term equity while increasing business investment and jobs.

"Massachusetts business tax laws are a hodgepodge of poorly conceived measures that violate the most fundamental principles of tax equity. They discourage business from locating in the Commonwealth and serve alternately as a target for revenue-hungry state government and a mechanism for dispensing largess to special pleaders," said an April 2008 reform proposal study by the Beacon Hill Institute at Suffolk University, Boston.

The study laid out a proposal for comprehensive business tax reform that is fair, revenue neutral and that would have a positive effect on economic growth. The institute proposed business tax reforms that would broaden the base by eliminating credits and loopholes and lower the rate for almost all business entities to 5.3 percent. Using a modeling program created by the institute, the study's authors project the state would lose about $86 million in the first year of implementation, or about 0.4 percent of current revenue, but there would be an immediate (but small) first-year gain in local tax revenue.

"This minuscule loss in revenue is a small-enough price to pay in order to achieve equity in the taxation of business and to turn the state tax code into an engine for attracting, rather than repelling, business," the study said.

In addition, the state's reformed tax system would allow businesses to create more than 4,000 new private-sector jobs in the first year. Subsequently, business investment could increase by nearly $120 million annually.

Barring reform, the institute concluded, companies would "continue to engage in tax-avoidance strategies as long as (overall tax) rates remain high."

A 2005 study of the Michigan Economic Growth Authority (MEGA), the state's primary tax-incentive program, completed by the Mackinac Center for Public Policy, was so highly critical of MEGA that it recommended ending the program altogether.

The Midland, Mich.-based institute center assessed the history of the program, which is Michigan's agent for selecting companies to receive single business tax credits in return for creating new facilities and jobs. Through 2004, more than $1.8 billion in tax relief was offered to more than 200 companies through 230 agreements valued at more than $3 billion when including other state and local incentives, such as property tax abatements, job training subsidies and infrastructure improvements.

Of 56 agreements meant specifically to create jobs, only 10 were shown to have created the number of direct jobs originally projected within the expected time frame, the Mackinac Center study found. And for 127 agreements measured, only 38 percent met original job-creation expectations. Thus, the study's authors said, MEGA's estimates of job creation "were unreliable."

Further, the study said that MEGA "did not improve" the state's or the counties' per-capita personal income, employment or unemployment rate; counties that didn't host companies receiving MEGA deals fared as well as counties that did; it didn't affect aggregate income or employment in manufacturing and warehousing (industries targeted by the program); and caused a temporary shift to higher construction employment without increasing overall employment.

The Mackinac Center proposed that, "given the underperformance of MEGA projects, the program's manifest lack of economic impact in its first seven years and the inherent difficulties in making such a program work, it would probably be best to cancel the MEGA program." It said the state has alternative tools to improve its business climate that are more likely to be effective.